On July 23, 2014, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation1 and second Post-Program Monitoring discussion with Sri Lanka and considered and endorsed the staff appraisal without a meeting.2
Sri Lanka’s economic growth has been one of the fastest among Asia’s developing economies in recent years. After falling to 6.3 percent in 2012, real GDP growth accelerated to 7.3 percent in 2013—driven primarily by a pickup in services activity, and supported by manufacturing and construction, but also benefiting from an increase in net exports. Inflation has remained low, falling to 4.7 percent at the end of 2013 and to 3.2 percent year-on-year in May 2014. Fiscal consolidation has continued, with the overall fiscal deficit falling to 5.9 percent of GDP in 2013. A strong recovery in exports in the second half of 2013 and into 2014, combined with declining imports and continued inflow of remittances and services receipts, has bolstered the balance of payments. Together with issuance of external debt, this has allowed the Central Bank of Sri Lanka to accumulate international reserves. Monetary policy has been accommodative, but private credit growth has been slow.
The short-term outlook appears broadly positive, as Sri Lanka is well positioned to benefit from the global economic recovery and particularly stronger growth in advanced economies. Real GDP growth is expected to remain robust at about 7 percent in 2014, while inflation is likely to remain in the mid-single digits. The government has targeted a further reduction of the fiscal deficit to 5.2 percent of GDP, which should allow for even more reduction of public debt. With a continued robust export performance, the current account deficit is expected to narrow further and allow for some additional accumulation of international reserves.
Near-term risks appear moderate given the ongoing recovery of advanced economies and a relatively benign outlook for international commodity prices. Adverse climatic events (such as the recent drought) remain a chronic source of vulnerability. Medium-term risks center on the potential for slower-than-projected growth in the advanced economies, tighter external liquidity conditions and chronic turbulence in international capital markets (negatively affecting rollovers and borrowing costs), and continued weakness in government revenues, which could threaten fiscal and debt consolidation objectives.
Executive Board Assessment
In concluding the 2014 Article IV consultation with Sri Lanka, Executive Directors endorsed the staff’s appraisal as follows:
Sri Lanka’s recent economic performance has been better than expected—particularly given some headwinds from chronic market turbulence and climatic shocks. While there remain weak spots in economic activity (such as agriculture, which has been negatively affected by recent drought), strong activity in traditional sectors such as garment manufacture, and new sectors such as tourism and services bode well for the near and medium-term outlook. This is complemented by a sustained reduction in headline and core inflation—bringing a new and welcome level of stability which has hopefully fed into a new set of public expectations regarding inflation.
The government has remained solidly committed to fiscal consolidation and reduction of public debt as a mainstay of macroeconomic stability. In this context, and given rising economic growth, the mission saw the fiscal stance for 2014 as appropriate, but raised concern about the composition of further consolidation. Capacity in expenditure and commitment control has increased, enhancing the government’s ability to curtail spending to meet fiscal objectives. However, given sizeable investment needs, the staff was of the view that spending cuts may have reached their effective limit, and that the burden of adjustment needed to fall more squarely on increasing revenue. Particularly if Sri Lanka is to maintain current growth momentum and foster economic development and diversification, high and sustained levels of public spending on infrastructure and human capital will be essential. Tackling the issue of tax expenditures and broadening the tax base will be essential. The mission appreciated the steps taken thus far, but was of the view that the pace of reform in this area could reasonably be accelerated. There is also room, in the mission’s view, to take another look at the medium- and long-term strategy for debt reduction, and consider a more ambitious debt target (more strongly associated with reduced vulnerability) over a longer time horizon.
The current, supportive stance of monetary policy is appropriate given the decline in inflation and weak private credit growth. However, the overall picture is complex and requires close monitoring. On the one hand, with economic activity apparently on the rise and private credit (outside of pawning activity) beginning to show signs of recovery, the authorities should be ready to adjust rates as needed to ensure price stability—particularly given the long lags involved in monetary transmission. On the other hand, the current low inflation environment and the apparent change in inflation expectations offers an opportunity for a downward shift in the interest rate structure that might benefit the investment environment (and borrowing costs) over the medium term. Given the mix of signals, a cautious approach is warranted and the staff believes policy rates should remain on hold for the near term.
Exchange rate policy remains broadly appropriate, but should be monitored in light of developments in the balance of payments and inflation, and the commitment to flexibility maintained. Staff’s analysis indicates that the exchange rate is broadly in line with fundamentals, and staff saw merit in central banks’ purchases to build its reserves, which remain on the lower end of most reserve adequacy metrics. However, staff also cautioned that the persistent stability of the rupee (vis-à-vis the US dollar) that has arisen as a side effect of foreign exchange absorption by the central bank since the fourth quarter of 2013 carries risks. First, it may create the perception that the rupee is implicitly fixed—a point supported by the shift in exchange rate classification from “managed float” to “stabilized” under the IMF’s Annual Report on Exchange Rate Arrangements. This perception could lead market participants and firms to hold un-hedged foreign exchange risk on their balance sheets. Second, should external balance continue to improve and inflation stay low, it could gradually lead to increasing currency misalignment. The central bank should thus be prepared to allow sufficient exchange rate flexibility to adjust to fundamental pressures, while limiting intervention to accumulation of reserves and smoothing short-term volatility.
Recent improvements in the trade and current account balances notwithstanding, Sri Lanka remains vulnerable to external shocks. Medium-term sustainability will depend on maintaining an outward orientation, diversification of the export structure, and a judicious use of foreign borrowing—particularly given the rapid increase in debt servicing costs that have accompanied the shift from bilateral concessional debt to new loans on commercial terms. The Market Access Debt Sustainability Analysis (MAC-DSA) highlights the sensitivity of Sri Lanka’s debt sustainability to growth and foreign exchange shocks. The staff urges caution with respect to external borrowing through the banking system.
Financial sector consolidation has potential benefits in the form of economies of scale, new products and services, and a greater resilience (via a stronger capital base) to shocks. The benefits of consolidation would likely be more rapid if fewer restrictions were placed on restructuring operations. Continued progress on corporate governance is also key. Close supervision during and after the consolidation process could also help avoid some of the pitfalls encountered by other countries in episodes of financial sector restructuring, such as excessive credit growth. Consolidation may also result in increased concentration and hinder effective competition if larger and state-owned banks continue to grow and dominate the banking sector.